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Gasoline Prices Can NEVER be Low Again…Until they are..

I have been watching and been involved in discussions regarding whether drilling for oil can drive down the price of oil (and gasoline) I am amazed how many conservatives buy into the view that:

‘Gee, producing more oil will not drive down the price’. And then they proceed to quote this or that study that says ‘increasing oil production will have very little impact on price’

For those of you who buy this argument (including Obama). You have just earned an ‘F’ in economics.

Let me fill you in on how academic research is done. Most academic studies are conducted in a static framework. That is, they assume the world today is how the world will be tomorrow, or how the world operated in the past is exactly how it will operate in the future. If this method of analysis were correct, then the economist Malthus would have been correct and today all the world’s population would be suffering from tremendous starvation. (after all, Malthus showed that food production was linear function while population growth was exponential. Thus showing we were doomed)

However, anytime the price of a resource is high, people figure out better ways to conserve on that resource or improve the methods of obtaining that resource (Malthus did not consider improved per acre crop yields which is why the world population enjoys more food per person than anytime in history).

Oil fields previously thought uneconomical are now very profitable and this oil is being brought to market. This increase in oil supplies has tended to keep prices lower than they would have been. Keep in mind that we have pumped a tremendous amount of dollars into the world economy creating tremendous disruptions in financial markets and commodity prices such as oil.

I have no idea where oil/gas prices will be in the future. Here is why…

Demand from developing countries may continue to increase, but so might production not just in the US but also around the world.

China’s bubble in real estate may finally come crashing down killing the global demand for oil.

New North Sea oil finds may or may not be brought quickly to market.

Refining capacity may not be enough to meet potential increases in world demand/supply.

US production potential that is greater than all the oil in Saudi Arabia, but will it continue to be developed?

There is not particular reason why gasoline prices in real, inflation-adjusted prices cannot get down to $2.50 again. Somehow we believe that the same mechanisms that drove prices up quickly do not work in reverse. (Gee, people once thought housing prices would increase forever too) But recent history has shown us that it is folly to make such conclusions. The following chart shows the inflation adjusted price of gasoline. But what it really shows is that gasoline prices fluctuate (They go up and they go down)

Notice how real gas prices in 1981 were almost as high as today. Just 5 years later, they were lower than they had been for the previous 70 years!